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Key Points
• Investment strategies emphasizing dividends have not worked in recent years.
• We think, however, that this will likely change in the years ahead.
• Historically, dividends have been an important, if not the most important driver, of long-term stock market returns.
Many investors are familiar with the “Dogs of the Dow” strategy for investing. Developed by Michael O'Higgins in 1991, the strategy maintains that by investing in the ten securities in the Dow Jones Industrial Average with the highest dividend yield each year, an investor can generate returns that are greater than those from investing in the index itself. If this is true, does the strategy also apply to the broader stock universe?
A number of past studies focused on dividend paying stocks and their long term returns, and most of them supported the idea that dividend paying stocks are an important part of any portfolio. In aggregate, these studies have shown that dividends, rather than capital appreciation, are the primary drivers of superior long-term total return, both in the United States and abroad. Over time, dividend-paying stocks tend to produce a greater total return, with less risk, than their non-dividend paying counterparts. A more recent study by Cambridge Associates (September 2009) also concluded that “Dividends have always been (and always will be) the main determinant of equity returns, as they are the primary method by which companies return profits to shareholders…The long-term record for dividends has been quite impressive. They have accounted for an average 39% of quarterly S&P 500 total returns since 1900.”
Given the variety of evidence supporting the idea that dividends are an important element of total return in the long run, it seems fair to say that history has provided good reasons to believe that dividend paying stocks should not be ignored.
Dividend Paying Stocks in 2009
While we experienced quite a run in the equity markets last year, dividend stocks were left behind. At the end of 2009, dividend paying stocks in the S&P 500 had returned an average of 35%, while members of the index that do not pay dividends had returned an average of 70%. The graph below shows the total return of the stocks that paid dividends versus the ones that did not pay for 2009; it is clear that there has been a difference in performance:
Even when the dividend paying stocks are analyzed by quintile we see the discrepancy in total return for 2009 of dividend paying stocks versus non-dividend paying stocks in the S&P 500. In this analysis, the dividend paying stocks are broken down by quintile based on their dividend yield, which is calculated by dividing the annual dividends per share by the price per share. In other words, the dividend yield identifies how much cash you are receiving for each dollar that you have invested in a certain stock. As you can see, the stocks with the highest dividend yield significantly lagged in performance last year.
Staying Away from Dividends
This trend of underperformance manifested itself prior to 2009, with dividend paying stocks failing to perform as well as their non-paying counterparts in a number of recent years. In addition to their underperformance, a variety of other factors have prompted people to argue against investing in dividend paying stocks.
Some suggest that there are better uses for a company's capital than paying a dividend, and that the payment of a dividend prevents a company from buying back stock or re-investing in itself, and thereby working to grow earnings. Additionally, some warn that investors can get caught up in a “search for yield,” and sacrifice investing in the best stocks for riskier assets that simply have a higher yield. Finally, while many believe that the economic recovery is gaining traction, there is always the risk of a correction in the stock market. If this were to happen, there is the distinct possibility that some companies would be forced to downsize their dividend payout. While investors would likely continue to receive some sort of dividend, the prospect of it decreasing in size might dissuade them from investing in dividend paying securities in the first place.
However, while some may cite these reasons as support for avoiding dividend paying stocks, we at Kobren Insight Management are among those who see investment in this area as an opportunity, and believe that dividend paying stocks are a valuable part of any portfolio.
The Benefits of Dividends
We believe that dividend paying stocks will perform well in the years ahead, and should not be ignored for a number of reasons. First, dividends are a signal of a company's financial health. A company that is paying a dividend is likely to be in a sound situation financially, which after 2008, is an increasingly important factor in choosing investments. Additionally, while they may not provide the same levels of return when the market is trending higher, dividends offer some downside protection during turbulent markets. If we consider the performance of dividend paying stocks in 2008 as shown in the graph below, it is clear that they could be an important piece of a person's portfolio, providing a “cushion” when the road gets bumpy.
What Next?
It is time to let history guide investors as they move back into equity markets and away from low-yielding fixed income investments. Choosing dividend paying stocks will allow them to pick up additional yield, as well as the knowledge that they are likely invested in financially sound companies. Additionally, investors can expect dividend growth as the economic recovery continues to gain traction. Importantly, investment in dividend paying stocks can help to protect investors from market turbulence.
Finally, it is also worth considering the simple impact that dividends can have on an investor's cash flow. To illustrate this significance, look no further than Apple CEO Steve Jobs. Jobs owns approximately 138 million shares of The Walt Disney Company, which he received when he sold Pixar Animation Studios to Disney in 2006. Disney's stock has paid $.35 per share each year for the last three years, resulting in over $48 million in income for Mr. Jobs each year. What makes this even more significant is the fact that this dividend income is taxed at 15%, rather than the 35% he would normally pay as a function of his tax bracket6. While most investors cannot hold dividend paying stocks on this scale, this provides empirical evidence of how significant dividend income can be.
Clearly, there are benefits from holding dividend paying stocks. A multitude of studies have shown dividends to be the most important contributor to total return in the long run, and have identified dividend paying stocks as providing greater return with significantly less risk. In addition, companies with high dividend payouts have been shown to experience a higher level of future earnings growth relative to firms with low payout ratios7. Importantly, if we see the slower economic growth that many predict, or even a correction, dividends will be able to provide a consistent and predictable form of income, despite a likely slowdown in earnings growth. Thus, we believe that dividend paying stocks should not be ignored in the years ahead and play a specific role in a well-crafted portfolio of investments.
David Lebovitz
Research Analyst
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